U.S. Economy: Sinking in an Ocean of Newly-Minted Money

At one time or another we have all heard it said that "you cannot get there from here." Much the same can be said of the current state of the US economy. Every prominent economic pundit is focusing on falling demand as the economy's nemesis. Nouriel Roubini points out that "85 percent of aggregate demand — consumption and fixed investment — is now in free fall." It's even worse than that because final demand as it is calculated does not include inter-business spending (spending between the stages of production). If this were taken into account the picture would change from grim to downright scary. That Treasury bills have been trading at negative rates is evidence enough of the markets fearful state.

In response to the crisis the fed forced the fed funds rate down from 1 per cent to between 0 per cent to 0.25 per cent. The real funds rate is now negative. (If the rate is 0 per cent and the inflation rate is 5 per cent then the real rate of interest is a negative 5 per cent). Some commentators feel that the present negative rate is not high enough and argue that it took a much higher rate to get the Reagan boom moving. But they overlook the obvious fact that a higher negative rate requires a higher inflation rate. It is clear that this view is based on the egregious error that money is neutral and that the successful manipulation of interest rates is one of the keys to maintaining a successful rate of capital accumulation. This is a very dangerous line of thinking and one that the fed adheres to.

To expand demand (a euphemism for an inflationary policy) the fed is engaging in what economists call "quantitative easing." In plain English, the fed is adding to its balance sheet by purchasing assets from the banks. When the fed does this it adds to the banking system's reserves and forces down the rate of interest. One can get a good idea of how much money the fed has injected into the banking system from the fact that since September the fed has accumulated more than $2 trillion in assets. This was supposed to stimulate business borrowing and hence investment. Well, it ain't working, which I think has Bernanke in something of a panic. However, as the eminent British economist D. H. Robertson observed 82 years ago:

While there is always some rate of money interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one. (Banking and the Price Level, Augustus M. Kelley, 1989, p. 81. First edition 1926).

During the Great Depression three American economists noted:

The market rate of interest conceivably may stand at zero, but if the average return to capital is represented by positive losses and all that will result from borrowing is more losses, loanable funds will not be employed to finance new productive activity. (C. A. Phillips, T. F. McManus, R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States, The Macmillan Company, 1937 p. 233).

By now the importance of expectations should have been fully grasped by the economic pundits. Instead we get such stuff as "the velocity of money is collapsing as the recession deepens." There is no velocity of money and money does not circulate. Money always changes hands and it is always — if only momentarily — part of some one's cash balance. What is being misinterpreted as "falling velocity" is a perfectly rational decision by consumers to reduce their demand for credit while simultaneously raising their demand for cash balance. This behavior is precisely what we should expect from the public once an economy slides into recession.

Despite the fact that the fed has been expanding the money supply at a frightening pace mainstream economists are still largely unfazed. Shiller argued in The New York Times that "inflation is no longer the fundamental risk" and that all Obama needs to do is to make "full employment a primary target" and "Americans' confidence in the economy would be swiftly restored". (To Build Confidence, Aim for Full Employment, 14 December 2008).

But this is exactly what they are aiming at, which is why Bernanke is trying to raise the inflation rate. He adheres to the discredited Phillips curve concept, according to which there is an inverse relationship between the rate of inflation and the level of unemployment. Therefore a little more inflation will lower the unemployment rate. But unanticipated inflation — which is what the Phillips curve is based on — is just a devious way of pricing people into work by using inflation to cut real wage rates. This is something Keynes admitted when he stated:

Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods [consumption goods] (The General Theory, Macmillan-St. Martin’s Press, 1973, p. 9).

Austrians tried to alert their fellow economists to the fact that this policy would lead to a continuous rise in prices while still fueling the boom-bust cycle. Moreover, a situation would arise where we would find inflation and heavy unemployment coexisting. (Very few people know that from the middle of 1933 prices began to rise and continued to do so in spite of the heavy unemployment). Nevertheless, Keynesians still argue for more and more monetary expansion to keep the economy afloat, even as the economy continues to sink. What these economists have not grasped is that the recession is the adjustment process. By trying to reverse it they are in fact making things worse.

Time and time again I have stressed that fractional reserve banking is the root cause of the boom-bust cycle. I have also stressed that the market always gets the blame. It's no different today. David Nason, The Australian's New York correspondent, was echoing the prejudiced view of those who know nothing of market processes when he wrote that "the unfolding financial crisis continues to illuminate the idiocies of deregulated, anything-goes capitalism" which is the result of "30 years of free market foolishness." (US needs to stand up to hedge funds, 27 October 2008).

Like the rest of his fellow free market critics Nason is not only ignorant of economic principles he is also equally ignorant of economic history and the history of economic thought. Unfortunately, it is ignoramuses like Nason who get to shape public opinion and prejudice it against free markets.

Comments

[Alan von Al...:]

Good commentary. Thanks also for covering Australia. I don't object to fractional reserve private banking, provided that such banks aren't indemnified by a fiat legal tender monopoly with fictional "assets" of government IOUs and worthless MBS.

2008 Dec 22 10:14 AM

[Moon Kil Woong:]

The velocity of money they are talking about is where the money supply was turned into CDS and CDO contracts and then spun around about 100 times from $400 billion to $40 trillion dollars over a course of 3 or 4 years. The reason you don't see it is called Base 1 which allowed banks to hide all their gambles off their balance sheet because basically they aren't really an investment. Duh.

This was done to help banks leverage themselves out of the dot com mess. So you are 100% correct in your analysis. That's why there is no velocity of money now. Actually, there should be no money at all if you cleared all this ficticious accounting. It accounts for about the same as the net worth of all Americans.

Now you know how hoplessly stupid the banking system got under Alan Greenspan and Bush Jr's administration that asked every regulator to take a 8 year nap.

So now the Fed has been adding trillions to it's balance sheet to remake money to try to get some velocity going again. Unfortunately, since no one knows the total liability of the CDS and CDO contracts still, nor who owns them or owes them, no one feels very confident doing any loans. Would you?

So the real question is, when will the banks, Fed, Treasury, and government own up to this derivatives mess and clean it up. Otherwise, we are in limbo no matter how much the fed inflates. There is a big hole in the baloon and it's going CDSSSSSSSSSSSSSSSSSSSS...

2008 Dec 22 02:28 PM

[BlackyBlack:]

constructe - yes! finally, someone besides me has connected the huge cds creation to money supply. This is huge. The fact that that money creation scheme dried up is the reason for the present contraction. The system needed that kind of huge counterfeiting op to feed its growth.

I suspect that they don't want to fix the derivatives problem because well heck some people are still making a lot of money selling them (albeit different types). And how are they going to spin the clean up effort when its the same people cleaning up that created the mess. It was easy to sell the crash when you can blame it on subprime people. My thought is that they are stalling and burning the bodies. Face transplants anyone?

2008 Dec 22 03:47 PM

[silverwood:]

This article by L. Rockwell fit well with the above, read it you'll enjoy it.

Madoff Explained

By: Llewellyn H. Rockwell, Jr



-- Posted Monday, 22 December 2008, Source: GoldSeek.com



The mystery of Bernard Madoff will be storied a hundred years from now. As history's biggest financial criminal, he took a cheap rip-off that you can use at home – the Ponzi scheme – and turned it into a global empire worth some $50 billion.

One ingredient was financial intelligence. Madoff had buckets of it. Early in his career, he was the real deal, an actual innovator. He combined this with an amazing lack of conscience, for his scam was rooted most fundamentally in lying and stealing. The difference between him and all who came before was his grand scale, the grandest scale imaginable.

There is a saying in the world of Austrian economics about the business cycle. The puzzle is not to explain business failures. Those are part of the normal course of life, and the sign of a healthy economy. The puzzle is to explain the "cluster of errors" that appears at the beginning of a recession. How could so many have been so wrong about so much at the same time? The business cycle is a system-wide failure, not merely the mistaken judgment of a few.

So it is with Madoff's scheme. The mystery isn't how one person was able to fool a few. The scheme in which yesterday's "investors" are paid off with the money of today's victims is known in all places and probably all times – and it always goes belly-up to the originator's complete disgrace. It is a classic example of how moral laws are self-enforcing in the world of economics.

The critical difference this time is that Madoff ran his scheme during an economic boom, a time when people's normal sense of incredulity is put on the shelf. This is part of the grave cultural distortion introduced by funny money. Money is the most widely demanded good in society, and the Fed is making new quantities of it not as a reflection of new real wealth, but purely as an administrative decree.

There is a sense in which funny money literally drives everyone crazy, leading to what is sometimes called the "madness of crowds." Guido Hulsmann explains it all in his remarkably timely and revealing new book: The Ethics of Money Production. With artificial stimulation from the credit machine, multitudes are willing to believe in something that cannot possibly be true. In Madoff's case, it was that he could, even in falling markets, earn 15–20% a year without risk.

Why not? Most everyone believed in some version of the myth. We believed that house prices would go up and up despite the reality that houses are physical things that deteriorate from the instant they are finished, just like cars or computers or anything else. Why did we believe this about houses? Again, you have to look to the fraudulent money system to see why.

And we believed that we could all become millionaires by putting our money in the stocks of companies that weren't actually earning money or paying dividends, companies whose wealth was entirely based on infusions of cash from the stock market which in turn were based on the belief that others would buy the stocks and so on. In other words, we believed that something out of nothing was possible, and anyone who didn't believe it was a chump. It’s exactly what people believed during the other great inflations of history.

What's more, we believed that buying these stocks constituted not consumption, but savings for the future. In fact, people routinely attacked official savings data on grounds that they did not include what people were "saving" in terms of their stock market accounts. In a similar way, people were measuring our national wealth not in terms of accumulated capital, but rather through consumption data, as if granite kitchen counters in bigger houses were a measure of wealth instead of the opposite: the depletion of wealth.

The left is big on attacking the salaries of investment bankers, and they were indeed outlandish. But these too represented not a unique problem, but more evidence of inflationary finance. In a bubble economy, the money chases what is most fashionable, and financial services qualified. So the salaries represented market rates. What was wildly distorted was the market itself.

Now let's talk about government finance during these years. The market tried to correct itself from 1999–2001, but the government wouldn't tolerate it. Instead, it used every sign of downturn as an excuse to keep the illusion going, creating billions and billions in new dollars. The Fed drove interest rates lower and lower despite the non-existence of savings available to back them up.

(Low interest rates in a sound money system are a reflection of accumulated capital and deferred consumption. When you see the Fed pushing them down during a boom, it is creating a dangerous mirage.)

Did anyone stop and wonder where the government was getting all this money to pump up the system? Yes, the Austrian economists warned us. The pages of Mises.org and LewRockwell.com were filled with alarms. But it was something people wanted to ignore. We are talking about human nature: the desire to believe in things that do not exist. The government was happy to fuel this sense because it gave the Fed, its connected industries, and the state more power and more money in the short term.

Madoff's scheme played into the belief that wealth was not something to work for, but something to scheme for. It could be generated by playing your cards right, hooking into the right networks, and finding the right "investments." The people with whom he dealt had, it turns out, some internal sense that there was something a little bit shady about the whole operation. But they dispensed with this sense when the fat checks arrived, and concluded that whatever was making this perpetual motion machine operate, it did work.

But listen: the government right now is using the same tactic to convince you that it is saving you from the recession. The whole scheme partakes of the same sense of denying reality that characterized Madoff's scheme. And I'm not just talking about Social Security, which is almost an exact replica of the Ponzi version, except that at least Charles Ponzi didn't force people to give him money. I'm speaking of something broader. The entire financial system that is propped up by the Treasury and the Fed is based on the same idea: that something out of nothing is possible.

So they will jail Madoff. Wall Street would flog him if it could. He is disgraced for all of history. But meanwhile, the likes of Bush, Bernanke, Paulson, Obama, and all the rest are still riding high, even though their scheme is far larger and more egregious.

Most of us like to believe that we wouldn't have been tricked by Madoff. But are you being tricked by the elites who claim that they can conjure up a trillion dollars to stabilize our economy by clicking a few buttons on a computer screen? Most people are. Certainly the press seems to have bought it. Many people were outwitted by Madoff. Many more people are today being outwitted by the government and its central bank. And it will all end in disgrace and disaster, only on a far, far grander scale.

2008 Dec 22 06:57 PM

[Mike from a...:]

Recently, a fellow blogger gave me permission to share this adaptation of the famous "dead parrot" skit by the "Monty Python" team.
I wish i could say i wrote it myself, but hope it brings a smile. Hope it is in the spirit and scope of this excellent article..........i think so.

Heres Joel.

Ok, I spent way too much time on this. You may be glad to know that I
did copy the sketch text and edited it. Not like I whipped this up
from scratch. lol Enjoy!


US Taxpayer: 'Ello, I wish to register a complaint.

US Taxpayer: 'Ello, Thief?

Hank Paulson: What do you mean "thief"?

US Taxpayer: I'm sorry, I had a 401K. I wish to make a complaint!

Hank Paulson: We're closin' for the election.

US Taxpayer: Never mind that, my lad. I wish to complain about this
market what I invested in not half an hour ago from this very
exchange.

Hank Paulson: Oh yes, the, uh, the DOW...What's,uh...What... wrong with it?

US Taxpayer: I'll tell you what's wrong with it, my lad. It's dead,
that's what's wrong with it!

Hank Paulson: No, no, it's uh,...it's bottoming.

US Taxpayer: Look, matey, I know a dead market when I see one, and I'm
looking at one right now.

Hank Paulson: No no it's not dead, it's, it's bottomin'! Remarkable
market, the DOW idn'it, ay? Beautiful returns!

US Taxpayer: The returns don't enter into it. It's stone dead.

Hank Paulson: Nononono, no, no! It's bottoming!

US Taxpayer: All right then, if it's bottomin', I'll restore its
confidence! 'Ello, Mister Market! I've got a lovely investment for you
if you show...

(Paulson approves a bailout)

Hank Paulson: There, it recovered!

US Taxpayer: No, it didn't, that was you bailing it out!

Hank Paulson: I never!!

US Taxpayer: Yes, you did!

Hank Paulson: I never, never did anything...

US Taxpayer: 'ELLO MARKET!!!!! Testing! Testing! Testing! Testing!
This is your nine thirty opening bell!

(Goes out and buys a car and a house to stimulate the economy watches
the market break support.)

US Taxpayer: Now that's what I call a dead market.

Hank Paulson: No, no.....No, it needs another bailout!

US Taxpayer: ANOTHER BAILOUT?!?

Hank Paulson: Yeah! You froze the credit market, just as it was
recoverin'! Credit markets freeze easily, major.

US Taxpayer: Um...now look...now look, mate, I've definitely 'ad
enough of this. That market is definitely deceased, and when I
invested in it not 'alf an hour ago, you assured me that its total
lack of movement was due to it being volitile and scared following
prolonged bad news.

Hank Paulson: Well, it's...it's, ah...probably priced in.

US Taxpayer: PRICED IN!?!?!? What kind of talk is that?, look, why did
it crash the moment I my trade closed?

Hank Paulson: The DOW prefers to correct every now and again!
Remarkable market, id'nit, squire? Lovely returns!

US Taxpayer: Look, I took the liberty of examining that market when I
got it home, and I discovered the only reason that it had been doing
so well to begin with was that you had been propping it up.
Hank Paulson: Well, o'course it was propped up! If I hadn't propped
that market up, it would have clobbered the economy, caused massive
unemployment, and BOOM!

US Taxpayer: "BOOM"?!? Mate, this market wouldn't "boom" if you didn't
keep interfering! But now it's bleedin' demised!

Hank Paulson: No no! It's priced in!

US Taxpayer: It's not priced in! It's passed on! This market is no
more! It has ceased to be! It's expired and gone to meet 'is maker!
It's a stiff! Bereft of life, it rests in peace! If you hadn't bailed
it out it'd be pushing up the daisies! 'Is economic processes are now
'istory! It's off the twig! It's kicked the bucket, 'e's shuffled off
'is mortal coil, run down the curtain and joined the bleedin' choir
invisibile!! THIS IS AN EX-MARKET!!

Hank Paulson: Well, I'd better bail YOU out then.

Hank Paulson: Sorry squire, I've had a look 'round the back of the
shop, and uh, we're right out of bailouts.

US Taxpayer: I see. I see, I get the picture.

Hank Paulson: I got a Treasury bill.

US Taxpayer: Pray, does it have a positive yield?

Hank Paulson: Nnnnot really.

US Taxpayer: WELL IT'S HARDLY A BLOODY REPLACEMENT, IS IT?!!???!!?

Hank Paulson: N-no, I guess not.

2008 Dec 22 11:59 PM

[Trinitymaster:]

I said about the same thing in the comment section of another blog. Why won't people wake-up? Get out the crazy glue, people- Humpty Dumpty is teetering on the edge.


On Dec 22 02:28 PM constructe wrote:

> The velocity of money they are talking about is where the money supply
> was turned into CDS and CDO contracts and then spun around about
> 100 times from $400 billion to $40 trillion dollars over a course
> of 3 or 4 years. The reason you don't see it is called Base 1 which
> allowed banks to hide all their gambles off their balance sheet because
> basically they aren't really an investment. Duh.
>
> This was done to help banks leverage themselves out of the dot com
> mess. So you are 100% correct in your analysis. That's why there
> is no velocity of money now. Actually, there should be no money at
> all if you cleared all this ficticious accounting. It accounts for
> about the same as the net worth of all Americans.
>
> Now you know how hoplessly stupid the banking system got under Alan
> Greenspan and Bush Jr's administration that asked every regulator
> to take a 8 year nap.
>
> So now the Fed has been adding trillions to it's balance sheet to
> remake money to try to get some velocity going again. Unfortunately,
> since no one knows the total liability of the CDS and CDO contracts
> still, nor who owns them or owes them, no one feels very confident
> doing any loans. Would you?
>
> So the real question is, when will the banks, Fed, Treasury, and
> government own up to this derivatives mess and clean it up. Otherwise,
> we are in limbo no matter how much the fed inflates. There is a big
> hole in the baloon and it's going CDSSSSSSSSSSSSSSSSSSSS...

2008 Dec 23 03:12 AM